Correlations Gone Wild!

Correlations, typically symbolized by the Greek letter rho,
provide an historical relationship between two moving items.
So-called modern portfolio theory assumes correlations over time
hold, or at least revert, to the mean. Because correlations among
investment classes are typically less than one-for-one and returns
are not known, the theory leads us to believe a diversified
portfolio is best.

Since last September, however, many correlations have gone to one
or at least are closer than ever before. This means there is only
one trade available in the marketplace. Do you believe in a
recovery today, or not?

Long-term correlations between stocks and bonds (view chart) give us an indication of the
credibility of the Fed as an inflation fighter. Prior to 1986,
stocks rose and fell in conjunction with bond yields. This
relationship makes sense assuming bond yields move primarily due to
inflationary pressures. Higher bond yields portend higher inflation
and higher prices mean higher valuations of everything including
stocks. Of course, higher stock market returns could only be
achieved if you held stocks before inflation fears arose.

Then the Fed killed inflation or at least the idea of uncertain and
drastic moves of inflation. Since investors did not have to worry
about the uncertainty of long-term price movements, stock prices
began to move opposite to bond yields. During this period, higher
yields only meant higher interest costs for businesses (all of
which are levered in some fashion), reducing their ability to make
profits and leading to lower stock prices.

The Fed "made its bones" as an inflation-killer and the entire
economy benefited. With little price uncertainty, investors and
consumers became more confident making long-term commitments. For
example, the discount rate CFOs used when performing net present
value (NPV) analyses on new projects dropped, making more projects
feasible and the productivity boom ensued.

Today, the markets are telling us a different story. The return to
a positive correlation indicates the market's fear that the Fed
will fall behind the inflation curve. Whether or not that occurs is
the real issue.

The Fed operates as an independent entity. Though various important
nominations come from the executive branch and are confirmed by the
legislative branch, the Fed is profitable and funds its budget from
its own internal activities substantially reducing its political
ties to Congress. Indeed, there have been many studies done over
the years that come to this conclusion in other ways as well.

Ben Bernanke is potentially the Fed chairman for the next 11 years
- he must be renominated by the President every four years. People
don't take this job for the money; they take it for the prestige.
The ego satisfaction of driving the world's strongest economy must
be quite incredible.

Given the long-lasting credibility the Fed enjoys today, it is
difficult to imagine that Bernanke will risk that credibility by
keeping policy too loose for too long. Instead, it is likely he
will wish to tighten credit - first through reining in the balance
sheet, then by aggressively raising interest rates - before the
economy catches traction.

This is all about legacy and Ben does not want to be remembered as
the guy who killed the Fed's credibility.

Key Developments

April's trade deficit increased slightly to $29.2 billion, but a
far cry from the $67.7 billion record level set in August 2006.
Since then, both imports and exports have declined as global trade
has drastically reduced. In the recent month, exports declined 2.1
percent while imports fell 1.4 percent.

May retail sales rose 0.5 percent after falling 0.2 percent in
April. Stripping away auto sales, retail activity also rose 0.5
percent after falling 0.2 percent in April. Retail activity has
been moving sideways since the end of 2008 as consumers remain
stymied by the poor current economy and uncertain outlook on the
future.

Correlations, typically symbolized by the Greek letter rho,provide an historical relationship between two moving items.So-called modern portfolio theory assumes correlations over timehold, or at least revert, to the mean. Because correlations amonginvestment classes are typically less than one-for-one and returnsare not known, the theory leads us to believe a diversifiedportfolio is best.

Since last September, however, many correlations have gone to oneor at least are closer than ever before. This means there is onlyone trade available in the marketplace. Do you believe in arecovery today, or not?